The Bank of England’s latest round of bank stress tests in November 2018 painted a reassuring picture of bank resilience. The message was that the UK banking system is now so strong that it can come through another crisis that is more severe than the last one and still be in good shape.
How do we know this? Because the stress tests tell us, claims the Bank. However, the truth is that the Bank’s stress tests are useless at detecting bank fragility. And how do we know that? Because this fragility is apparent from banks’ leverage. So do you believe the results of the stress tests or do you believe the leverage numbers?
The centrepiece of the Bank of England’s oft-repeated narrative about the banking system is that bank capital ratios are high and still rising. The banks are strong.
The measure the Bank relies on is the ‘CET1 ratio’, the ratio of Common Equity Tier 1 (CET1) capital to Risk Weighted Assets (RWAs). As of the third quarter of 2018, the average CET1 ratio across the big five UK banks was 14.7%. This number looks impressive until one realises that the denominator is meaningless, because it is highly gameable and the banks are expert at this game. We should throw this ratio into the bin.
A better measure is bank leverage. Leverage is total assets divided by (CET1) equity.
What is bank leverage?
As of the third quarter of 2018, the average leverage across the big five was 20.7. This number is book value, however, and a more accurate measure is market-value leverage, which is 34.4.